I. Introduction

The Appellate Tax Board (Board) recently issued three decisions involving entities claiming qualification as a manufacturing corporation, a research and development corporation, or both. Such qualification would entitle these entities to certain tax benefits, including the sales/use tax exemptions under G.L. c. 64H, §§ 6(r), (s), for purchases of materials, tools, fuel and machinery for direct and exclusive use in research and development by qualifying domestic or foreign manufacturing corporations or research and development corporations within the meaning of G.L. c. 63, §§ 38C, 42B, respectively. Qualification as a manufacturing corporation also allows the corporation to use the single sales factor apportionment under G.L. c. 63, § 38(l) as well as an investment tax credit under G.L. c. 63, § 31A. A corporation properly classified [1] as a manufacturing corporation under G.L. c. 58, § 2 is also entitled to claim the exemption of certain property from local taxes [2] under G.L. c. 59, § 5, clause Sixteenth (3).

The purpose of this TIR is to announce the Commissioner's response to these decisions. In particular, with respect to a corporation's qualification as a manufacturing corporation, this TIR announces that in two of the cases, The First Years, Inc. and Duracell, the Commissioner will follow the analysis and conclusion of the Board with respect to qualification as a manufacturing corporation in substantially similar fact patterns. As explained below, the Commissioner does not acquiesce in the portion of the Duracell decision relating to its qualification as a research and development corporation. The Commissioner has filed an appeal of the Board's decision in Onex Communications Corporation v. Commissioner.

II. Summary of Decisions and the Commissioner's Response

A. The First Years, Inc., A.T.B. Docket No. C267626 (September 17, 2007)

In The First Years, Inc. v. Commissioner of Revenue the Board issued Findings of Fact and a Report on its ruling that the taxpayer (TFY) was "engaged in manufacturing" for purposes of G.L. c. 63, § 38C, and therefore was entitled to be classified as a domestic manufacturing corporation under G.L. c. 58, § 2 for the tax year 2003. The Board found that TFY, a Massachusetts corporation, was engaged in the business of designing, manufacturing and selling its line of child-care related products such as cups, bottles, teethers and baby monitors. The products were mass-manufactured by unrelated third parties. TFY's only Massachusetts activities were design and research of new products and improving existing products, along with marketing new and existing products.

TFY's overall operations and product development process consisted of several distinct phases. The process began with creation and approval of a concept brief and a detailed sketch of the proposed product. During this phase, the quality and safety tests to which the potential new product should be submitted were determined. After the product was approved, TFY or a third party designer created models of the product with Computer Aided Design machines and had the tooling and molds produced by third parties. TFY transferred the tooling, molds and other data to third party manufacturers located in Asia, but retained ownership of these items. The tooling and molds were used directly in the manufacturing process.

In analyzing TFY's activities, the Board utilized the line of analysis set forth in a number of Massachusetts cases addressing the meaning of "engaged in manufacturing." It concluded that TFY's activities were essential and integral to the overall manufacturing process. Noting that TFY employees were integrally involved in every step of the product-creation process from the conception of an idea for a new product through the completion of the final product offered for sale to consumers, including extensive testing regimens at various stages of product development, the Board concluded that TFY was engaged in manufacturing to a substantial degree and, therefore, it qualified for classification as a manufacturing corporation. In determining whether the manufacturing was substantial (a specific requirement for classification as a manufacturing corporation) the Board ruled that the TFY met this requirement since it derived all of its receipts from the sale of the manufactured products.

Commissioner's response:

In determining qualification as a manufacturing corporation, the Commissioner will follow the analysis and conclusion of the Board as applied to situations involving substantially similar fact patterns. Thus, in cases where products are being produced through an outsourcing arrangement and a taxpayer's design and creation of such products is integral to producing and bringing products to market, the Commissioner will treat its activities as constituting manufacturing, as the Board found in this case.

B . Onex Communication Corp., A.T.B. Docket No. C271834 (September 11, 2007)

In Onex Communications Corp. v. Commissioner of Revenue the Board ruled that for the tax periods at issue the taxpayer was entitled to an abatement of use tax on its purchases of items used directly and exclusively in research and development. The exemption question turned on whether, during the period in question, Onex qualified as either a foreign "manufacturing corporation" or "research and development corporation" within the meaning of G.L. c. 63, § 42B. The Commissioner argued that Onex was neither. The Board concluded that Onex qualified as a foreign manufacturing corporation. It did not make a finding whether the taxpayer qualified as a research and development corporation.

Onex was a foreign corporation maintaining its principal place of business in Bedford, Massachusetts. It was formed to develop application-specific integrated circuits to enable switching, routing, and transmission of multiple types of voice and data traffic. Onex asserted that its activities centered on taking its flagship product, an application-specific integrated circuit chip set (the OMNI chip) from abstract concept to production and commercial sale. Onex lacked the equipment needed to make the chip itself. After development of the OMNI chip, it outsourced the production of the OMNI chip to IBM, which exactly followed the instructions of OMNI's research and development "blueprint" (a computer-aided design including technical specifications for hardware and software components, as well as detailed manufacturing instructions). After producing an initial run of early stage chips, the chips were tested and analyzed at the Onex laboratory. The blueprint was then refined and sent to IBM, which proceeded to manufacture and ship production quantities of the OMNI chip to Onex. The chips were not sold commercially by OMNI during the period in question; the A.T.B. found that "[t]he commercial roll-out of the product occurred subsequent to the audit period in 2002."

In addressing whether Onex qualified as a manufacturing corporation, the Board stated a case-by-case analogical mode of analysis was appropriate in interpreting the phrase "engaged in manufacturing," consistent with Massachusetts authorities (citations omitted). In so doing, it found that the items produced at the Onex facility constituted more than the production of prototypes. It found that the taxpayer's "development of the blueprint and the fabrication of the OMNI chip according to [Onex's] intricate specifications represented a process of transformative change . . . out of which came a new commodity with capabilities that had never existed before." Id. at 1000, citing Houghton Mifflin Co. v. State Tax Comm'n, 423 Mass. 42, at 46 (1996). The Board further found that the activities of the taxpayer caused a sufficient degree of refinement to source materials both tangible and intangible that its activities could be considered an essential and integral part of the overall process which yielded the OMNI chip. Id. at 998-999. The Board found that Onex carried out essential and integral steps in the total manufacturing process which brought a new product to the marketplace, and ruled that Onex was "engaged in manufacturing" within the meaning of G.L. c. 63, § 42B. The Board also found that the fact that no final product was actually manufactured during the period in question was irrelevant. Accordingly, the purchased items were ruled to be exempt from use tax under G.L. c. 64I, § 7(b) and c. 64H, § 6(r) and (s).

Commissioner's response:

The Commissioner respectfully disagrees with the analysis and conclusion of the Board that Onex qualified as a manufacturing corporation during the period in question, and has filed a notice of appeal of the decision. The Commissioner contends that the activities of the taxpayer in Onex, in contrast to those of the taxpayer in The First Years, were limited to research and development activities that preceded the manufacture of any product, whether through outsourcing or otherwise, and did not rise to a level sufficient to treat Onex as being engaged in manufacturing within the meaning of G.L. c. 63, § 38C or 42B during the periods at issue.

C. Duracell, Inc. v. Commissioner of Revenue, A.T.B. Docket No. C26646 (August 28, 2007)

In a fact-driven decision, the Board ruled that Duracell qualified as both a research and development corporation and a manufacturing corporation within the meaning of G.L. c. 63, § 42B, and consequently, it was entitled to an abatement of sales and use taxes on its purchases of tangible personal property used directly and exclusively in research and development.

Duracell was a foreign corporation engaged in the development, manufacturing, marketing and sale of batteries in the United States and abroad. It had a facility in Needham, Massachusetts, where the principal activity was the development, improvement and enhancement of new and improved batteries and battery manufacturing technologies to suit the needs of new devices and technologies in which batteries are used by consumers ("battery R&D"). Substantially all of Duracell's receipts were derived from the sale of batteries that it manufactured. Duracell had no other facilities in Massachusetts during the periods at issue.

While battery R&D was the principal activity taking place at the Needham facility, Duracell did not sell any of its R&D services to unrelated third parties, nor did it receive any direct receipts from unrelated third parties for activities taking place at the Needham facility. Rather, the parties stipulated that more than two-thirds of the income recorded on the books of the Needham facility as a division of Duracell stemmed from the charge-out of battery R&D services to affiliated entities. Those records also showed that virtually all of the expenses associated with the Needham facility were research and development expenses.

1. Duracell's qualification as an R&D corporation

The Board examined whether Duracell had receipts from research and development, and if so, whether more than two thirds of those receipts assignable to Massachusetts were from research and development activity, as required by G.L. c. 63, §42B for qualification as a research and development corporation. The Commissioner argued that because the Needham facility did not engage in the commercial sale of batteries and did not sell battery R&D services to an unrelated party, it had no receipts for purposes of the statute. Duracell argued that because its only activity in Massachusetts was battery R&D, by necessity all of its receipts assignable to Massachusetts were derived from research and development.

The Board focused on Duracell's book income entries maintained for its Needham facility's R&D related operations, which stemmed from the charge-out of research and development services. Reasoning that "in order for the Needham facility to continue to operate, it must have had income or receipts", [3] Id. at 916, the Board concluded that since the principal activity of the Needham facility was R&D, and since that location was Duracell's only location in Massachusetts, entries reflected on Duracell's books pertaining to its charge-out expenditures for the Needham facility constituted receipts from research and development. Accordingly, the Board ruled that Duracell qualified as a research and development corporation under G.L. c. 63, § 42B.

2. Duracell's qualification as a manufacturing corporation

The Board considered Duracell's qualification as a manufacturing corporation, as that term has been interpreted and developed through many years of case law. Rejecting the Commissioner's argument that the taxpayer's activities were confined only to the production of prototypes, the Board found that Duracell's activities, which included sending items produced at its Needham facility to equipment manufacturers for trial use in their products, and generation of thousands of batteries virtually identical to the products found in stores, transcended the prototype stage and amounted to the manufacture of tangible personal property. It found that these activities fell in line with the "production of products . . . in multiple quantities," Id. at 919, referred to in the Commissioner's Manufacturing Corporation regulation, 830 CMR 58.2.1(6)(b)(5).

Commissioner's Response:

The Commissioner will follow the Board's analysis and conclusion regarding Duracell's qualification as a manufacturing corporation and will apply the analysis to other taxpayers in substantially similar fact patterns. However, the Commissioner disagrees with the Board's analysis and conclusion that Duracell qualified as a research and development corporation, and will not acquiesce to the application of that portion of the Board's analysis. Specifically, the Commissioner does not agree that Duracell had the requisite Massachusetts receipts from research and development necessary to qualify as a research and development corporation. In the opinion of the Commissioner, the rationale of the Board in Duracell regarding R&D classification equates research and development costs and activity with the presence of qualifying R&D receipts in a manner that does not comport with the controlling statute, either as in effect in the periods in question [4] or as subsequently amended. [5] Due to the Commissioner's concurrence with the Board's conclusions regarding the taxpayer's qualification as a manufacturing corporation, the Commissioner will not seek judicial review of the Board's research and development analysis in this case.

/s/Henry Dormitzer
Henry Dormitzer
Commissioner of Revenue

HD:MTF:wrd

February 1, 2008

TIR 08-2



[1] See 830 CMR 58.2.1, Manufacturing Corporations, for additional information on the classification process.

[2] Classification as a research and development corporation will also result in a local property tax exemption in cities and towns that have elected this option. See 830 CMR 64H.6.4(10)(b).

[3] Since the term "receipts" is not defined in the statute, the Board consulted dictionary definitions as well as case law construing § 42B and concluded that a broad construction of the term is consistent with the legislative intent of the statute and the construction of the language of the statute as established by case law. Id. at 914.

[4] During the periods at issue in Duracell, G.L. c. 63, § 42B required that a corporation be primarily engaged in research and development and derive two-thirds of its Massachusetts receipts from such activity. R&D expenditures were not a separate basis for qualification.

[5] In 2003, subsequent to the tax periods at issue in this case, the statute was amended to allow corporations to qualify if they had sufficient expenditures allocable to research and development in Massachusetts. While the charge-out entries arguably might have reflected qualifying expenditures under the amended statute, the Board did not reach that issue because expenditures were irrelevant to the period in question. The Commissioner observes that the amended statute states an express distinction between R&D expenditures and receipts, and provides different tax benefits to those R&D corporations qualifying under the expenditures test and those qualifying under the receipts test.